Netflix Q2 Earnings: Subscriber Growth Impressive But International Margin Concerns Still Remain

Netflix‘s (NASDAQ:NFLX) stock jumped 12% in after-hours trading following its Q2 2015 earnings announcement on July 15th. The company reported strong subscriber numbers and its global subscriber base now stands at 65.6 million. Our take on Netflix is that its overall subscriber base will continue to grow in the coming years but the rate of growth in domestic subscribers is likely to come down due to increased competition and potential market saturation. On the other hand, International subscriber growth will remain robust in the near future as the company expands into various new territories with the aim of having a presence in 200 countries by the end of 2016. Netflix’s domestic margins continue to improve but the international expansion is hurting international margins, which continue to remain negative. However, we expect the company’s international segment to start breaking even by 2017. Netflix’s increased focus on original content is also a positive as it enhances the desirability of the streaming service. However, the company’s spending on content does raise some concerns.

Netflix recently went for a stock split and we are currently in the process of updating our price estimate for the company.

See our complete analysis for Netflix

Subscriber Growth Strong, But Is It Sustainable?

All eyes were on subscriber additions in the streaming segment and Netflix did not disappoint. The company added 3.3 million subscribers this quarter, creating a Q2 record and eclipsing the 1.7 million it added during the same period last year. ^[1] Domestically, Netflix added 0.9 million subscribers, which soundly beat its Q2 guidance of 0.6 million. ^[2] The company’s domestic subscriber base currently stands at 42.3 million. Netflix has held its own in the domestic streaming market amidst the recent influx of multiple streaming options. The streaming service has a tendency of being viewed as a complementary service rather than a competing service to the various other options available for consuming content, whether it be traditional pay-TV or the more recent online options. Additionally, the success of Netflix’s original content has improved viewers’ perception of the overall brand. The company is no longer considered just an aggregator of popular content from other networks and has come of age as a provider of engaging and interesting content on its own. Accordingly, we believe that Netflix’s domestic subscriber base will continue to grow in the next couple of years but there will be less potential for surprises on the upside.

Netflix also delivered a stellar performance in the international segment and the subscriber base grew by 2.37 million customers. This number soundly beat the 1.12 million subscriber additions the company reported a year ago. The company expects the growth in subscribers to continue and hopes to add 3.55 million subscribers globally for Q3 2015, much higher than the 3.02 million it added during the same quarter last year. Netflix launched into Australia & New Zealand in March and met with a positive initial response. The company is also poised to launch into Japan, Spain, Italy and Portugal later this fall. (Related – A Closer Look At Netflix’s Foray Into Japan) Netflix is also exploring options for entry into densely populated countries and lucrative markets such as China and India. (Related – China Makes Sense For Netflix, But It Won’t Be Easy) Consequently, we believe that international subscriber growth will remain robust in the near future as the company expands into various new territories with the aim of having a presence in 200 countries by the end of 2016. The subscriber growth in the International segment has been exceptional so far, with the subscriber base increasing from 1.9 million customers in 2011 to 23.3 million by the end of Q2 2015. ^[3] Taking a long term perspective, we believe that Netflix can cross 61 million international subscribers by the end of our forecast period if it continues on its current expansion plans.

Domestic Margins Improve; International Margins Negative But Will Improve In Coming Years

Netflix’s domestic streaming margin stood at 33.1% for the first three months of 2015, an improvement of 140 basis points over the previous quarter. ^[1] The company had earlier stated that it intends to improve domestic streaming margins by 200 basis points per year but now believes that it can improve even further as a larger portion of global and original content costs will be absorbed by the company’s ever growing international territories going forward. ^[2] The company intends to cross the 40% threshold by 2020, a target we believe to be achievable.

Unfavorable currency movements and the additional costs undertaken due to aggressive expansion put Netflix’s international streaming margins under pressure. The international streaming contribution margin came in at -20% for the quarter and the company expects it to be around -15% for the next three months. ^[1] The company intends to complete its global expansion over the next two years and then generate material global profits. This is possible as Netflix will start experiencing operating efficiencies as it grows in its target countries. The marketing expenses will also come down as a percent of sales once the company establishes itself in these countries. We believe that Netflix’s international segment will start to break even by 2017 and will start having positive contribution margin from 2018 onward. It will then stabilize at around 30% by the end of our forecast period.

Spending On Original Content Is A Necessary Evil

Netflix noted that the success of its original content has improved perception of the overall brand. The company’s original programming has garnered critical acclaim by scoring multiple Emmy, Golden Globe and Academy Award nominations and several wins in the last two years. Netflix had earlier mentioned that its original content has cost the company less money, relative to Netflix’s viewing metrics, than most of its licensed content. ^[4] The company’s first original film Beasts of No Nation will be made available to its subscribers this October. The film is part of Netflix’s burgeoning repertoire of original content. The company has plans to release 320 hours of original content in 2015, including new and returning series, films, documentaries and stand-up comedy specials. This figure is three times the amount of original programming Netflix released in 2014. Acquiring more content inevitably results in higher spending. Consequently, the company’s streaming content obligations increased by $300 million during the quarter and currently stand at $10.1 billion. ^[1] The streaming content obligations had earlier increased by $2.2 billion during the year 2014. ^[3] But Netflix has maintained in the past that this increase is fairly consistent in terms of its scaling with the business and revenues. We expect these obligations to continue to grow.  As Netflix launches into additional international territories, it will need to acquire content specific to the tastes and preferences of the target audience.

View Interactive Institutional Research (Powered by Trefis):

Global Large Cap | U.S. Mid & Small Cap | European Large & Mid Cap

More Trefis Research

1. Q2 15 Letter to shareholders, Netflix Investor Relations [↩] [↩] [↩] [↩]
2. Q1 15 Letter to shareholders, Netflix Investor Relations [↩] [↩]
3. Netflix’s SEC Filings [↩] [↩]
4. Q4 14 Letter to shareholders, Netflix Investor Relations [↩]